The LEI for China increased by 1.1 percent in May from the month before, up from April’s 0.9 percent expansion. The six-month growth rate continued to expand as well, indicating that growth may pick up moderately due to policy support in the second half of the year. The CEI rebounded from April, up 0.8 percent in May, but the six-month growth rate continued to moderate, underlining the current weakness throughout China’s real economy.

Credit growth has been the single consistent driver of LEI growth over the past several months, which suggests that any acceleration of growth in China’s economy will likely be credit- and/or policy-induced for some time, and that weakness persists in the real economy.

Real estate activity improved in May, adding to this month’s increase in the LEI, but doubts are significant as to whether this rebound can be sustained. Furthermore, any strong revival of real estate activity could reignite the hazardous asset bubble in the sector while exacerbating China’s various investment imbalances.

Nevertheless, policy loosening is beginning to counteract the recent slowing in economic activity, even as serious risks remain both domestically and externally, not least of which is that a too-strong policy response will increase system-wide leverage – thus increasing the risk of a future, more significant correction.

To date, the gradual loosening of policy appears to be working, and our baseline expectation is for a moderate rebound beginning in the third quarter of 2012. However, with increased uncertainty both at home and abroad, the risk of an over-correction is rising, particularly in the run up to the leadership transition later this year. What’s more, monetary policy has certainly become more complicated, if not less effective, as the level of credit demand has come in doubt over recent weeks and capital inflows have waned.

For now, policy appears able to defend the government’s 7.5 percent growth target for the year, but the economic and policy waters are clearly getting choppier.

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